Heritage Financial Corporation

Hello everyone and welcome to today's call. My name is Drew and I'll be your conference operator today. At this time, I would like to welcome everyone to the Heritage Financial Q4 and year-end earnings call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. To ask a question, please press start followed by one on your telephone keypad. If you change your mind, please press start followed by two to withdraw the question. I will now turn the call over to your host, Jeff Dewell, CEO. Please go ahead.

Thank you, Drew. Welcome to everybody who called in and those who may listen later. This is Jeff Dewell, CEO of Heritage Financial. Attending with me are Brian McDonald, President and Chief Operating Officer, Don Henson, Chief Financial Officer, and Tony Chalfant, Chief Credit Officer. Our fourth quarter earnings release went out this morning pre-market, and hopefully you have had the opportunity to review it prior to the call. We have also posted an updated fourth quarter investor presentation on the investor relations portion of our corporate website, which includes more detail on our deposits, loan portfolio, liquidity, and credit quality. We will reference the presentation during the call. Please refer to the forward-looking statements in the press release. We are reporting a somewhat noisy quarter that ultimately sets us up well for 2024 and beyond. That so-called noise can be attributed to active balance sheet management and expense reduction measures. When we started to run the preliminary budget for 2024, non-interest expense was running around $171 million for the year. That, coupled with continued pressure on margins, caused the management team to take a hard look at our org structure in Q4, and we were able to get that number down to a run rate more around 162 million. In the end, expense reduction actions included contract rationalization, elimination of management layers, streamlining certain back office operations, and exiting our retail mortgage platform. all of which will be referenced in this presentation. We continue to see pressure on deposit pricing in Q4, and we expect to see this continue for the near term. Deposit balances declined modestly in Q4, and the mix of deposits continues to partially shift to higher rate products. Loan growth was strong in Q4, running at a 7% annualized rate. Credit quality remains strong, resulting from our long-term practice of actively managing the loan portfolio. We have ample liquidity, a low loan-to-deposit ratio, and a solid capital base. Going forward, we will keep a sharp eye on expenses while we focus on growing loans and deposits. We'll now move on to Don Henson, who will take a few minutes to cover our financial results.

Thank you, Jeff. I will be reviewing some of the main drivers of our performance for Q4. As I walk through our financial results, unless otherwise noted, all of the prior period comparisons will be with the third quarter of 2023. I want to start by covering some actions that significantly impacted earnings for Q4 and are expected to improve earnings in future periods. First, we repositioned a portion of our investment portfolio, which resulted in a pre-tax loss of $10 million during the quarter. We sold 152 million of securities with a weighted average yield of 2.41% and purchased 141 million of securities yielding 6.08%. Including the yield and cash not yet reinvested at year end, we are expecting an annualized interest income pickup of about $5 million from these transactions, resulting in an earn back period of approximately two years. Second, we incurred certain costs related to expense management measures in order to lower expenses in future periods. These included $1.5 million in contract negotiation fees, which will lower costs of the related contract over a six-year period, $320,000 due to the write-off of a contract that we will not be replacing, and $148,000 of severance payments to terminated employees. As mentioned in the earnings release, these costs, in addition to approximately $1.2 million of severance payments expected to be incurred in Q1, will result in annualized cost savings of approximately $5.3 million. These and other expense management measures are being taken to improve our performance in 2024 and beyond. Please see page 6 of the investor presentation for more information on these actions. Moving on to the balance sheet, loan growth was strong in Q4, increasing $69 million for the quarter. For the year, loan growth was $285 million, or 7%. Yields in the loan portfolio were 5%. for the quarter, which was five basis points higher than Q3. Brian McDonald will have an update on loan production and yields in a few minutes. Total deposits decreased $35 million during the quarter. The decrease was due to a decrease of almost $100 million in non-maturity deposits, partially offset by an increase of $64 million in CD balances. Customers continue to take advantage of the higher rate environment by lowering their excess balances in lower-paying non-maturity deposit accounts. These factors contributed to an increase of 25 basis points in our cost of interest-bearing deposits to 1.48% for Q4. Due to the current market pressure related to deposit rates, we expect to continue to experience an increase in the cost of our core deposits. This is illustrated by the cost of interest-bearing deposits being 1.56% for the month of December with a spot rate of 1.59% as of December 31. Investment balances decreased $21 million during Q4, partially due to the lost trade previously discussed. The security trades occurred from mid-November to mid-December. Therefore, the benefit of lost trade was not fully realized in Q4. Even without full realization of the lost trade benefit, the yield in the securities portfolio increased 16 basis points from the prior quarter to 3.15% for Q4. Moving on to the income statement, net interest income decreased $1.7 million from the prior quarter due to a decrease in the net interest margin and in average earning assets. The NIM decreased to 3.41% for Q4 from 3.47% in the prior quarter. The decrease in NIM was primarily due to the cost of interest-bearing deposits increasing more rapidly than yields on earning assets. We expect NIM to decrease further in Q1 2024 since NIM for the month of December was four basis points lower than it was for the entire quarter, Q4. The pace and duration of our decrease in margin will be highly dependent on continued increases in our cost of in-spring deposits as well as maintaining deposit balances. Our cost of deposits as well as deposit balances, as they level off, we expect to experience margin stabilization due to the repricing of adjustable rate loans in addition to higher origination rates on new loans. In addition, current rates on broker CDs are lower than those currently on our books, which will help mitigate other deposit cost pressures as these roll over. We recognize the provision for credit losses in the amount of $1.4 million during the quarter. The provision expense was due to a combination of loan growth and net charge off of $618,000 recognized during the quarter. Removing the impact of significant Q4 expense items previously mentioned, non-interest expense decreased from the prior quarter due partly to lower FTE levels. Average FTE was 803 for Q4 compared to 821 for Q3. These levels will decrease further in Q1 2024 and are expected to decrease to less than 780 by Q2. All impacted employees have already been notified. Due to the previously mentioned severance costs in Q1, Q1 non-interest expense levels are expected to be somewhat elevated from the go-forward run rate. Beginning in Q2, we expect the expense run rate to be between 40 and 41 million. All the regulatory capital ratios remain comfortably above well-capitalized thresholds, and our TCE ratio increased to 8.8% at year-end from 8.2% at the end of the prior quarter. This increase was due substantially to improvement in our AOCI as market rates improved the overall fair value of our securities portfolio. I will now pass the call to Tony, who will have an update on our credit quality metrics.

Thank you, Don. Credit quality at year-end remained strong and was stable throughout the year. As of year-end, non-accrual loans totaled just under $4.5 million, and we do not hold any OREO. This represents 0.10 percent of total loans and compares to 0.07 percent at the end of the third quarter. Non-accrual loans increased by 1.4 million during the quarter, however, were down by 24 percent over the last 12 months. Increases of just over 2.1 million in the quarter came from moving one C&I loan to non-accrual status. A portion of this loan was charged off during the quarter, and the remaining balance is fully guaranteed by the SBA. we expect to be fully repaid from the guarantee during 2024. Partially offsetting this increase was $746,000 in loans that were either upgraded to accruing status or were paid off during the quarter. Page 26 of the investor presentation reflects the significant improvement we have experienced in our non-accrual loan levels since the end of 2020. Loans that are delinquent more than 30 days and still accruing stood at 0.11% of total loans at year end. This is unchanged from the third quarter and is down from 0.17% of total loans at year end 2022. Criticized loans, those risk-rated special mention or worse, total just under 150 million at the end of the quarter. This is an increase of 15 million or 11% from the end of the third quarter. The largest driver of this increase was the downgrade of two significant C&I relationships. During the quarter, a $7.1 million relationship was moved to special mention, and a $6 million relationship was moved to substandard. Overall, criticized loans have trended modestly higher since the end of 2022, rising by 11% over this 12-month period. Our commercial real estate portfolio continues to perform well and has shown some improvement over the last 12 months. Total criticized CRE loans represent 3.4% of our total CRE portfolio and 2.3% of our entire loan portfolio. As of year end 2022, the percentages were 4.8% and 3.2% respectively. The credit quality of our office loan portfolio has remained stable over the last quarter and throughout 2023. This loan segment currently represents $556 million, or 12.8% of total loans, and is split evenly between investor CRE and owner occupied. The loans continue to be granular in size and diversified by geographic location, with little exposure in the core downtown markets. Criticized office loans are limited to just over $19 million, which is down modestly from the $21.5 million reported at the end of the third quarter. Page 25 of the investor presentation provides more detailed information about our office loan portfolio. During the fourth quarter, we experienced total charge-offs of $709,000, with the majority attributed to two C&I borrowing relationships. The losses were offset by $91,000 in recoveries, leading to net charge-offs of $618,000 for the quarter, which was referenced by Don earlier. We ended 2023 in a net recovery position of $277,000. While the recovery position was lower than 2022, loan losses remained very low when compared to historical norms. Page 28 of our investor presentation shows that we continue to outperform the average of our peer group in this important credit metric. While there was some modest deterioration over the last 12 months, The credit quality of our loan portfolio remains strong, and we are well positioned heading into the new year. The slight uptick in criticized loans during the quarter suggests a move towards a more normalized credit environment following a period of exceptionally high credit quality. We remain confident that our consistent and disciplined approach to credit underwriting is designed to generate solid credit performance in a wide range of business cycles. I'll now turn the call over to Brian for an update on loan production.

Thanks, Tony. I'm going to provide detail on our fourth quarter loan production results, starting with our commercial lending group. For the quarter, our commercial teams closed $187 million in new loan commitments, down from $217 million last quarter, and down from $329 million closed in the fourth quarter of 2022. Please refer to page 20 in the fourth quarter investor presentation for additional detail on new originated loans over the past five quarters. The commercial loan pipeline ended the fourth quarter at $329 million, up from $291 million last quarter and down from $536 million at the end of the fourth quarter of 2022. Loan demand continues to be moderate due primarily to the effects of higher interest rates. Loan growth for the fourth quarter was $69 million, up from $15 million last quarter due to more significant advances on construction commitments and higher balances on loans closed during the quarter. Please see slides 21 and 23 of the investor presentation for further detail on the change in loans during the quarter. Based on our current pipeline, we anticipate our growth rate will be mid-single digits over the next couple quarters. The deposit pipeline ended the quarter at $207 million compared to $171 million last quarter, and estimated average balances on new deposit accounts opened during the quarter totaled $55 million. This compares to $39 million in actual new balances on accounts added in the third quarter. Moving to interest rates, our average fourth quarter interest rate for new commercial loans was 6.93%. which is 48 basis points higher than the 6.45% average for last quarter. In addition, the average fourth quarter rate for all new loans was 7.04%, up 50 basis points from 6.54% last quarter. The increase is due to a combination of higher underlying index rates and widened spreads implemented in 2023. The market continues to be competitive, particularly for C&I relationships. The mortgage department origination volume and pipeline continued to be low in the fourth quarter. Ongoing low loan volume combined with uncertainty around when we could expect to see our mortgage business improve led to our decision to exit the retail component of this business line. The staff associated with the retail mortgage business are included in the non-interest expense numbers Don shared a few minutes ago. We expect to replace portfolio balance runoff with periodic residential loan purchases, including through an existing wholesale production channel. I'll now turn the call back to Jeff.

Thank you, Brian. As we mentioned earlier, we're pleased with our performance in the fourth quarter, which sets us up for 2024. While we continue to experience the challenges of this current rate environment, we're confident that the strength of our franchise will continue to benefit us over the long term. Our relatively low loan-to-deposit ratio positions us well to continue to support our existing customers as well as pursuing new high-quality relationships. We will continue to benefit from our solid risk management practices and our strong capital position. We will continue to focus on expense management and improving efficiencies within the organization. Overall, we believe we are well positioned to navigate the challenges ahead and take advantage of any potential dislocation in our markets that may occur. That is the conclusion of our prepared comments. So, Drew, we're ready to open up the call to any questions callers may have for us.

Thank you. We will now start today's Q&A session. If you would like to ask a question, please press start followed by one on your telephone keypad. If you change your mind, please press star followed by two. Our first question today comes from Jeff Rulis from DA Davidson. Your line is now open. Please go ahead.

Thank you. Good morning.

Good morning.

Just maybe a question for Don. On the margin side, I heard your comments about you know, expecting further compression. I wanted to kind of get the sense for with the security sale that's inclusive of that and kind of relative compression is that magnitude moderating 3Q, 4Q to 1Q.

Jeff, I'll be happy to answer that for you. As I mentioned, the December NIM dropped, but like I said, it didn't include all of the lost trade, but still with the cost of deposits increasing, although moderating, I do expect that we see NIM compression down again, maybe a little less so than we saw from Q3 to Q4, but still probably into the 330s for the quarter.

Okay, and if you could just remind us on kind of If and when we get some rate cuts, I don't know about the sensitivity of each 25 basis point cut, what that initially does and maybe a little further out the impact of the margin.

I think if I'm going to start with long-term, I think long-term more rate cuts will be beneficial because anytime we can get away from an inverted yield curve, that's going to That's going to help us out. But in the short run, with rate cuts, there's always a lag period on cutting deposit rates and having those repriced, whereas we have about $1.2 billion in floating rate assets. I will say, though, when you add up our broker CDs, other CDs, we have some floating rate public deposits and our exception price core deposits, that adds up to about $1.4 billion in and of itself that will reprice over a year also. So I think over a year, they'll kind of, I guess, reach equilibrium over rate cuts. But in the short run, I think it's going to hurt margin more. And I don't have necessarily a specific number for you, but But you can see the amount of floating rate that we have in each category.

Sure. And then just a couple of housekeeping, just on the fee income side, resumption of a normalized, and it's seven, it's seven and a half million clip. Is that a quarterly fair run rate?

I think what we did in Q4 was, obviously X the losses on the investments. And of course, we wouldn't have any gains on sale of loans other than those. So I think that's a pretty good run rate.

Okay. And then the tax rate for 24, should we think about 16 or 17%?

Yeah, I think somewhere between 16, 16 and a half is probably kind of where we're we're going to end out.

Okay, I'll step back. Thank you.

Thanks, Jeff.

Just to reiterate, if you would like to ask a question, please press star followed by one on your telephone keypad. If you change your mind, please press star followed by two. Our next question comes from Matt Fedorchka from KBW. Your line is now open.

Hey, guys. Thanks for taking the questions. I wanted to see what you're seeing kind of with deposit balances, maybe with NIBs early into the year here, you know, if you have any insight to where you think they may bottom at and what the deposit flows are kind of looking like early into this year.

Don, you want to take that?

Sure. You know, we have seen continued decrease of our percentage of non-interest bearing. We're down to a little over 30%, I think 30.7 as of the end of the year. You know, pre-pandemic we were 31.6%, I think it was, but obviously we're in different rate environments. So at this point, I kind of based off the trends, I kind of would expect that overall percentage to drop into the, you know, the high 20s at this point. I don't necessarily see it going below that, but the trends continue as far as over the last few quarters. So I don't see at this point where it's going to slow down until we see maybe some changes in the rate environment.

All right, great. And then maybe on the other side with loans, I appreciate the guidance with mid-single digits. Maybe you guys could talk about where you're seeing some good opportunities for this year and where you think you might see the most growth in 2024?

Brian, you want to take that?

Sure. Matt, this is Brian McDonald. Really, it's broad-based. Our bankers have been calling with an added emphasis on C&I since last spring. We've always been a C&I banker, but as the market conditions changed, more of a heavy emphasis on full relationship. But it's really up and down the footprint. Of course, our new teams have more bankers with lower portfolio sizes, and so they're able to get out and call more than our bankers with large portfolios. But it's all across the network.

Great. Thanks. And then one more here. Are you guys any appetite or expecting any more restructurings this year at this time, or do you think that would be it?

restructuring the balance sheet? Yes. Yeah. Okay. Go ahead, Don.

Okay. We're considering it. We haven't made any final decisions on that. I would say it's a less attractive trade than it was last quarter or maybe even the quarter before that. So with potential longer earn-back periods and less income pickup, I will say that if we did another one, we'd probably try to keep it within Three years, as a reminder, the last one was two years, but we haven't made any final decisions.

Awesome. Well, I appreciate all the color, and thanks for answering the questions.

Thanks, Matt.

Again, if you would like to ask a question on today's call, please press Start, followed by 1 on your telephone keypad now. If you change your mind, please press Start, followed by 2. We have no further questions in the queue, so I'll hand it back over to Jeff for any closing remarks.

Well, thank you, Drew. Since there's no more questions, I guess we wrap up the quarterly call. We'll thank you all for your time and your support and your interest in our ongoing performance, and we'll hopefully see some of you soon.

That brings us to the end of today's call. There will be a replay available for the call. Please dial plus one eight six six 813-9403. Please use the access code of 301-843. That concludes today's Heritage Financial Q4 and year-end earnings call. You may now disconnect your line.